A recent decision of the Delaware Court of Chancery provides a scholarly and practical explanation of the onerous prerequisites that must be satisfied before a Caremark claim will meet the rigors of the demand futility analysis in order to justify the absence of pre-suit demand on the board.

The 82-page decision in Oklahoma Firefighters Pension & Retirement System v. Corbat, C.A. No. 12151-VCG (Del. Ch. Dec. 18, 2017), deserves to be read in its entire glory for an understanding of the important factual nuances, but for purposes of this short blog post I will highlight several of the most important legal principles with the widest applicability.

Background Facts: This lengthy opinion describes in great detail the important and extensive facts that are a necessary part of the reasoning and conclusion of the court.  The court praised the plaintiffs for using Section 220 and producing “a ponderous omnibus of a complaint.”

But, unfortunately for the plaintiffs, notwithstanding the extensive details alleged and the incorporation of many documents by reference, the complaint failed to demonstrate that it was reasonably conceivable that the directors acted in bad faith.

Key Principles Explained: One of the most noteworthy aspects of this decision was the comprehensive explanation of the many shades and hues that are part of the challenging prerequisites that need to be met in order to plead a successful Caremark claim.  The court described the following key principles involved in a Caremark claim:

  • The essence of a Caremark claim is an attempt by the owners of the company, its stockholders, to force the directors to personally make the company whole for the losses suffered when the corporation violates laws or regulations and as a result is subject to fines or penalties.
  • Caremark claims often involve the following two situations: (1) When directors fail to install a system whereby they may be made aware of and oversee corporate compliance with law; or (2) Where the board has an oversight system in place, but nonetheless fails to act to promote compliance. In the latter situation, the directors may be liable only where their failure to act represents a non-exculpated breach of duty.
  • Where the directors are on notice of systemic wrongdoing but nonetheless act in a manner that demonstrates a reckless indifference towards the interests of the company, they may be liable for a breach of duty of care, but in order to be liable when an exculpation clause applies, the inaction of directors in the face of “red flags” putting them on notice of systemic wrongdoing must implicate the duty of loyalty. To imply director liability, the response of the directors must have been in bad faith. That is, the inaction must suggest not merely inattention, but actual scienter. In other words, the conduct must imply that the directors are knowingly acting for reasons other than the best interests of the corporation. The court describes this as the “essence of a Caremark claim.” See footnotes 2, 3 and 4.

Demand Futility in the Caremark Context: The court explained that the well-known pre-suit demand requirements of Rule 23.1 require particularized facts showing that demand would have been futile. These stringent requirements differ substantially from the permissive notice pleadings governed solely by Chancery Rule 8(a).

  • Because director inaction is involved in a Caremark claim alleging violation of oversight duties, the applicable test is found in Rales v. Blasband, 634 A.2d 927 (Del. 1993)–as compared to the Aronson test.
  • In the context of a Caremark claim, a plaintiff must allege facts “that allow a reasonable inference that the directors acted with scienter which, in turn, requires not only proof that a director acted inconsistently with his fiduciary duties, but also more importantly, that the director knew he was so acting. See footnote 251.
  • The court added that one way to establish a connection between the red flags ignored by the board and corporate trauma, is to allege facts suggesting that “the board knew of evidence of corporate misconduct—the proverbial red flag—yet acted in bad faith by consciously disregarding its duty to address that misconduct.” See footnotes 255 and 256 (emphasis added).
  • Moreover, the corporate trauma in question “must be sufficiently similar to the misconduct implied by the red flags such that the board’s bad faith, conscious inaction proximately caused that trauma. See footnote 258.
  • In a particularly quotable portion of the court’s reasoning, the court emphasized that when the duty of loyalty is at issue: “A board’s efforts can be ineffective, its action obtuse, its results harmful to the corporate weal, without implicating bad faith. Bad faith may be inferred where the directors knew or should have known that illegal conduct was taking place, yet took no steps in a good faith effort to prevent or remedy that situation.”
  • The court also reasoned that the pleadings fell short in this case because: (1) The court could not infer that the defendants consciously allowed Citigroup to violate the laws so as to sustain a finding that they acted in bad faith. (2) The second problem was that the purported red flags were not waved in front of the defendant directors.
  • Importantly, as stated in many other Delaware decisions, “Delaware law does not charter law breakers, and a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profit by violating the law.” In this case, however, there were no allegations supporting an inference that any of the directors decided to cause Citigroup to break the law and pursue the profits.
  • The court’s concluding reasoning was that the “directors may be faulted for lack of energy or for accepting incremental efforts of management advanced at a testudinal cadence, when decisive action was called for instead” [,] but that does not satisfy the prerequisites for a Caremark claim. If it did, and if simple gross negligence were enough, it would discourage able persons from serving on boards and would make it difficult for them to bring business judgment to bear on decisions involving risk.
  • In sum, the court concluded that because: (i) the pleadings did not imply scienter on the part of the director defendants; and (ii) the bad results that plaintiffs point to do not imply bad faith; and (iii) there is no substantial likelihood of liability, therefore, for any of the director defendants, based on the facts alleged, demand was not excused, and the motion to dismiss was granted.

Supplement: Large volumes of commentary exist on the many cases discussing the issues addressed in this case. A prolific, nationally prominent corporate law scholar often cited in decisions of the Delaware courts, and friend of this blog, Prof. Stephen Bainbridge, in one of his many writings on this issue, provides insights on some of the seminal decisions on Caremark claims, and also quoted from an article I wrote on an earlier Chancery decision on this topic, that captures the essence of the nuances involved in this challenging topic.

The recent Delaware Supreme Court decision in Exelon Generation Acquisitions, LLC v. Deere & Company, No. 28,2017 (Del. Supr., Dec. 18, 2017), reversed the trial court ruling and rejected an earn-out claim based on the application of well-settled contract interpretation principles.

The specific contract terms that were interpreted are fairly sui generis and not widely applicable, in terms of the factual aspects of the trigger for the earn-out payment, but several contract interpretation principles are noteworthy for their wide-spread applicability.

Background Facts: In this case, Excelon agreed to make earn-out payments to Deere if it reached certain milestones in the development of three wind farm projects that were underway at the time of sale.  One of the projects became impossible to develop due to local ordinances that were passed.  The issue arose about whether the development of another wind farm 100 miles away, that was not referenced in the applicable agreements, could satisfy one of the milestones that would trigger the earn-out payment.

Key Contract Interpretation Principles: Several basic contract interpretation principles in this decision have widespread applicability:

  • Delaware adheres to an objective theory of contracts. Contract construction should be that which is understood by an objective, reasonable third party.
  • If a contract is unambiguous, extrinsic evidence may not be used to interpret the intent of the parties, to vary the terms of the contract, or to create an ambiguity.
  • One contract may incorporate discrete parts or terms from another contract without necessarily incorporating the entire contract. See footnote 33 (citing 11 Richard A. Lord, Williston on Contracts § 30: 25, at 234, 238 (4th ed. 1999)).
  • Extrinsic evidence cannot be used to interpret the intent of the parties or to vary the terms of the contract unless the contract suffers from ambiguity.
  • In interpreting an earn-out provision, the parties’ post-closing conduct may be used to determine whether there is a breach, but post-closing evidence cannot be used as an aid to interpreting the meaning of the contract when the contract is unambiguous.

In a split decision, the Delaware Supreme Court applied the nuanced standards for demand futility in the context of Caremark claims against Duke Energy Company.  In City of Birmingham Retirement and Relief System v. Good, No. 16-2017 (Del. Supr., Dec. 15, 2017), a clear majority of the Delaware Supreme Court, sitting en banc, found that demand futility was not adequately demonstrated in the context of Caremark claims, in light of the majority of the directors being independent.  That is, an insufficient showing of bad faith was pleaded. See footnotes 70 and 75.

Brief Background: The context of this decision was massive long-term environmental violations that resulted in multiple large fines.  The important facts in this decision were chronicled in detail in the 39-page decision, including the dissent.

Key Principles: The High Court’s majority opinion should be read by anyone who wants to fully understand the demand futility analysis under Delaware law.  A few of the key principles recited in the opinion include the following:

  • The fact that the board was aware of the circumstances resulting in environmental violations and fines “does not mean it consciously disregarded them—the presentations [to the board] show that the board was regularly informed of Duke Energy’s remedial actions—and the letters state that no governmental organization or agency addressed the issues, which does not show that the board disregarded them. See footnote 70.
  • The court also observed other cases that explain that Delaware courts routinely reject the conclusory allegations that because illegal behavior occurred, internal controls must have been deficient, and the board must have known so. Id.
  • A key distinguishing aspect between the majority opinion and the dissent in this case was explained in footnote 75: “. . . the question on appeal is not whether Duke Energy violated environmental laws. It did. Rather, the question is what the directors—a majority of whom were independent—knew about the violations and whether they ignored them. As we have shown, based on the specific arguments raised on appeal, the plaintiffs have not demonstrated a pleading stage reasonable inference that those directors knew Duke Energy: [(a)] was violating the law and [(b)] knew from the information presented to the board, that the Company ignored the violations.”

Dissent: The spirited dissent explained in great detail the facts which the Chief Justice viewed as  sufficiently supportive of a conclusion that the board had knowledge of long term environmental violations and that particularized allegations supported a non-exculpated Caremark claim. See, e.g., footnote 121.

In its first explicit clarification of Delaware law on stockholder ratification in many years, the Delaware Supreme Court provided a virtual restatement of the prerequisites for valid stockholder ratification of director actions. In doing so, Delaware’s High Court allowed a claim to proceed which challenged allegedly excessive director compensation.  In the case styled: In re Investors Bancorp, Inc., Stockholder Litigation, No. 169, 2017 (Del. Supr. Dec. 13, 2017; revised Dec. 19, 2017), the High Court also made important observations about demand futility standards.

Brief Background: The context of this decision involves an equity incentive plan that provides a compensation package for directors.  The stockholder approval of the plan in this case gave the directors ample discretion to determine their own compensation.  Some of the compensation that the directors awarded themselves amounted to several million dollars a year each, which reportedly was substantially higher than the comparable compensation paid to directors in similar companies.

The key factual aspect of the equity incentive plan involved in this case was that the plan approved by the stockholders did not provide meaningful limitations on the amount of compensation that the directors could award themselves. In particular, in the facts of this case, the directors had discretion to allocate up to 30% of all options or restricted stock available as awards to themselves.

Key Principles and Highlights of Decision:

  • Although a board is authorized to fix the compensation of directors based on Section 141(h) of the DGCL, when the board fixes its own compensation, it is a self-interested decision. If no other factors are involved, that decision will not be entitled to business judgment rule protection and when properly challenged will be subject to the entire fairness standard of review. See footnotes 34 to 36.
  • Stockholder ratification generally is allowable in three situations involving equity incentive plans: (1) When stockholders approve the specific director awards; (2) When the plan was self-executing, meaning the directors had no discretion when making the awards; or (3) When directors exercise discretion and determine the amounts in terms of the awards after stockholder approval.
  • Ratification cannot be used to foreclose the Court of Chancery from reviewing further discretionary actions when a breach of fiduciary duty claim has been properly alleged. This is so based on the truism that “director action is ‘twice-tested,’ first for legal authorization, and second by equity.” See footnote 81.
  • Another key principle with broad application is that “inequitable action does not become permissible simply because it is legally possible.” See footnote 83.

Court’s Reasoning: In this case, the stockholders did not ratify the specific awards that directors made under the equity incentive plan, thereby requiring the directors to demonstrate the fairness of the awards to the company. Sufficient facts were alleged to support a reasonable inference in this case that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves.

Demand Futility Issue: The court also addressed a demand futility issue. As readers well know, based on Court of Chancery Rule 23.1, demand is excused as futile when reasonable doubt is pled that: (1) a majority of the board is disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. See footnote 100.

The court reasoned that because all of the directors were alleged to have awarded themselves compensation, not just the outside directors, the court explained that:

“It is implausible to us that non-employee directors could independently consider a demand when to do so would require those directors to call in to question the grants they made to themselves. In other words, it strains reason to argue that a defendant-director could act independently to evaluate the merits of bringing a legal action against any of the other defendants if the director participated in the identical challenged misconduct.”

See footnote 101.

Therefore the court concluded that demand was excused for the claims made against all the directors.

A recent Delaware Court of Chancery opinion is an important tool for the toolbox of corporate and commercial litigators for upholding what the court refers to as “a survival clause”–which provides a contractually shortened period by which claims must be made. HBMA Holdings, LLC v. LSF9 Stardust Holdings LLC, C.A. No. 12806-VCMR (Del. Ch. Dec. 8, 2017).

Brief Background:  The facts of this case involved indemnification claims that were based on a contract.  That contract provided that a notice of claims for indemnification needed to be made within 30 days of the matter giving rise to such a claim.  The court found that the notice of claim was not given within that 30-day period.

Key Principles:  The court explained that Delaware enforces shortened statute of limitations based on contracts if the period is considered reasonable.  See footnotes 53 and 54.  The court found that a provision in the contract in this case that notice of claims for indemnification needed to be made within 30 days was enforceable.

Referring to these types of contract provisions as “survival clauses,” the court explained that Delaware courts uphold unambiguous survival clauses that, in effect, serve as shortened statutes of limitations. The claim in this case was barred because the applicable 30-day period passed, and therefore the claim was barred. This decision and the explanation of the law it applies, has great relevance to many similar contractual provisions.

The court also addressed the perennial issue of substantive, as compared to procedural, arbitrability.  That analysis was applied in the context of an Earn Out dispute in which the agreement required the parties to submit certain issues to a neutral accountant.

A recent Delaware Court of Chancery opinion enforced an oral agreement which involved a settlement by a corporation of claims by a stockholder to expand the board. The terms of the oral deal included the expansion of the number of members of the board of directors to allow for an additional two seats to be appointed by the stockholder with whom the settlement agreement was entered into orally. In Sarissa Capital Domestic Fund LP v. Innoviva, Inc., C.A. No. 2017-0309-JRS (Del. Ch. Dec. 8, 2017), the court granted a declaratory judgment based on a claim pursuant to Section 225 of the Delaware General Corporation Law.

This 72-page decision is must-reading for anyone who:  (1) seeks to enforce an oral agreement, especially regarding corporate governance issues; and/or (2) needs to find controlling legal authority and judicial reasoning to support the enforcement of oral settlements even when not formally documented in a fully executed written agreement.  Compare the recent Chancery decision in Zohar II 2005-1, Ltd. v. FSAR Holdings, Inc., C.A. No. 12946-VCS (Del. Ch. Nov. 30, 2017) (rejecting the request to enforce an unwritten understanding unsupported by contemporaneous documentation).

The most noteworthy point of this short letter ruling in which a former corporate officer is granted advancement pursuant to Section 145 of the Delaware General Corporation Law, in Kolokotrones v. Ninja Metrics, Inc., C.A. No. 12413-VCS (Del. Ch. Dec. 18, 2017), is that the court rejected an argument based on the fact that the underlying litigation for which advancement was sought had been concluded by the time that a formal order granting advancement was entered on the docket.  Although in theory, when the underlying claim that gave rise to any advancement right was dismissed or finally concluded, arguably that claim for advancement then became a claim for indemnification, assuming that the party seeking advancement prevailed, the court found that argument unpersuasive based on the procedural posture of this case.

The court explained that otherwise it would be placing form over substance and benefiting the defending party for its procedural “machinations.” In addition, the court did not want to reward the delay of the defending party to the detriment of the party seeking advancement.

Moreover, the original decision in this case was rendered as a bench ruling, and the letter ruling that denied a motion for reargument explained that the original decision had granted fees on fees. Thus, notwithstanding a prior final resolution of the underlying litigation that gave rise to the advancement claim, because fees on fees were granted for the advancement claim, simply because the underlying litigation concluded, does not, in the court’s words:  “under any view of the world, moot that claim.”

In connection with a recent decision granting a declaratory judgment to recognize the terms of and to enforce a loan, the Court of Chancery in the matter of Standard General L.P. v. Charney, C.A. No. 11287-CB (Del. Ch. Dec. 19, 2017), addressed several issues of practical importance to Delaware corporate and commercial litigators.  The background facts of this case were recited in a summary of a prior decision by the Court of Chancery in this matter appearing on these pages.

Highlights of Some Noteworthy Legal Principles Applied in this Decision:

  • When there is a Delaware choice of law clause, and the clause is broadly written, Delaware will enforce it as covering both tort claims and contract claims, even when asserted in affirmative defenses. See footnote 80.
  • A fraudulent inducement argument is “not available when one had the opportunity to read the contract and by doing so could have discovered the misrepresentation.” See footnote 97. Moreover, Delaware law also finds it unreasonable to rely on an oral representation that is expressly contradicted by the parties’ written agreement.
  • Unlike a slight breach of contract, a prior material breach of contract may excuse contractual performance. See footnotes 163 and 164.
  • The court discusses the four criteria to satisfy the requirement for an actual controversy when seeking a declaratory judgment pursuant to 10 Del. C. § 6501.

The Delaware Supreme Court issued an important decision a few days ago on the right to bear arms outside one’s home. This right includes at its core the right to self defense which is a natural right that every person is born with–an exalted right not shared with many of our laws. Thus, the importance of this decision and this bedrock topic both transcend the corporate and commercial issues that are the typical fare of these pages.

The High Court’s ruling in Bridgeville Rifle and Pistol Club, Ltd. v. Small, Del. Supr., No. 15, 2017 (Dec. 7, 2017), was based on Article I, Section 20 of the Delaware Constitution which expressly provides for much broader rights to bear arms as compared to the analogous provision in the Second Amendment to the U.S. Constitution. Although the specific focus of the court’s opinion, which is 143-pages long when the majority opinion and the dissent are combined, was the invalidation of regulations that in substance eviscerated the right to bear arms in state parks and forests, the court’s scholarly analysis and explication of fundamental principles has far-reaching applicability.

For example, the Delaware Constitution provides for the right to keep and bear arms for the protection of self, home, family, state and for recreational and hunting purposes. Those rights were added to our state constitution at Article I, Section 20, in 1987, but there has been doubt in some circles if those words really “meant what they said.”

In sum, a majority of the Delaware Supreme Court has now established that Article I, Section 20 means, among other things, that the natural right to defend oneself, recognized in the Delaware Constitution through the right to bear arms, extends beyond the home. Although it is not an unfettered right, and reasonable restrictions can be imposed, as of last week state agencies cannot impose regulations that have the net effect of eliminating or eviscerating the right to bear arms in state parks and forests.

It would be easy to write a law review article about the 143-page decision, that was buttressed by the 2014 Delaware Supreme Court decision in Doe v. Wilmington Housing Authority, that the author of these pages also argued–but that law review article will need to wait. The Doe case, also highlighted on these pages, recognized a right to bear arms outside one’s home, but this Bridgeville decision provides more doctrinal underpinning and a more thorough analysis of the reasons why this fundamental right extends beyond the home.

The Washington Post on Dec. 8 and the News Journal on Dec. 9 carried stories on this case.

A recent Delaware Court of Chancery opinion is useful for its explanation of those circumstances in which the court will allow both a breach of contract claim and a breach of fiduciary duty claim to be pursued in the same case against the same defendant.  See Capella Holdings, LLC v. Anderson, C.A. No. 9809-VCS (Del. Ch. Nov. 29, 2017).